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No room for complacency as UK firms struggle with pension costs

15 May 2017

I put in a response to the DWP’s 100+ page Green Paper consultation on the sustainability of final-salary-type pension schemes. My response was also lengthy, but I’ve summarised it for you below, although you can link to the whole thing from there if you want to.

I do feel that urgent attention must be given to consolidating schemes, moving away from the over-reliance on gilts (schemes need to ‘manage’ risk, not ‘minimise’ it) and using these huge sums of money more productively as we head towards Brexit. Almost all private schemes are closed and in five or ten years’ time those employers will have no interest in them, they can’t afford annuities and need a new self-sufficiency regime instead, as has effectively been done for BHS!

This is a really important issue.

EXECUTIVE SUMMARY

Main points:

  1. The Green Paper seems too complacent about the affordability and sustainability of DB pensions. UK DB pensions are the most expensive in the world and most private sector schemes are now closed as the costs have soared beyond any previous expectations.  Potential post-Brexit economic uncertainty makes contingency planning for such huge asset pools even more urgent.
  1. Quantitative Easing has undermined DB schemes. It has inflated estimated liabilities, increased annuity buyout costs and driven excessive investment in lower-return bonds.
  1. UK DB pension schemes are currently misallocating resources, to the detriment of the economy and future generations.
  1. DB scheme advisers are too focussed on minimising risk, rather than ‘managing’ risk. Optimising returns rather than maximising returns is required, allowing for upside to outperform liabilities when schemes are in deficit.  Just focussing on matching liabilities is not enough, schemes need to outperform if they are in deficit with a weak sponsor.
  1. DB pension assets would be better used to invest in growth-enhancing investments, rather than just chasing low-return ‘safer’ fixed income.
  1. The Regulator needs more powers to oversee consolidation or merger of smaller and medium sized schemes, to achieve economies of scale, improved cost-effectiveness and efficiency of investment management and better governance standards.
  1. Pooling assets can help ensure better standards of investment management, access to more diversified asset classes, better quality advice and professional risk management.
  1. Current annuity buyout requirements are too draconian. Using BHS example, the Regulator should devise a new self-sufficiency measure (perhaps technical provisions plus a margin) to allow employers to sever ties without having to meet full annuity buyout costs.
  1. A regime is needed for the future of closed schemes, to ensure the assets and liabilities can be managed effectively over the long-term.
  1. Open schemes are in a very different position from closed schemes. As most private sector schemes are now closed, their sponsors will have no economic interest in their liabilities in a few years’ time, as no staff will be accruing benefits.

 

Edited highlights of full response to Green Paper consultation:  You can link to the full response here http://bit.ly/2pNNjKl

 HIGHLIGHTS:

  • UK Defined Benefit (DB) pension schemes are the most expensive in the world and employers may be hampered by legacy liabilities.
  • Unless the employer is facing imminent bankruptcy, benefits can never be reduced, and even changing the benefits can be difficult.
  • The regulatory regime worked reasonably well for the past 12 years. However, the DB landscape has changed significantly over time.  Most private sector schemes are now closed and if we wind forward 5 or 10 years, the employer currently responsible for scheme funding will probably have no workers in the scheme, so why would they have an interest in supporting it?
  • Quantitative Easing has damaged DB schemes and their sponsors by inflating assessed liability values and the costs of annuity purchase. Government policy must adapt to the new realities.
  • With Brexit on the horizon and such huge uncertainty about the future, planning for a new DB landscape now is the prudent approach.
  • There is no room for complacency, given the medium term outlook for private sector schemes.
  • I disagree with the Green Paper conclusions that employers could afford to fund their schemes more fully, but are choosing not to. It is true that some employers are paying dividends which could cover the costs of their deficit repair relatively easily, but they also have to support their business and other staffing issues.
  • The DB system is currently in an inter-regnum period, leaving the Government and the Regulator with a difficult balancing act to strike at this time. On the one hand, before private schemes close altogether, trustees need to try to get as much money in as possible.  But, on the other hand, if forcing employers to put more in today will just mean the business is weaker or more likely to fail, especially if there is near-term economic post-Brexit dislocation, members’ interests will be jeopardised.
  • The draconian annuity buyout requirements are placing much bigger burdens on employers than they are equipped to cope with. It is also driving excess emphasis on fixed income investments, at the expense of higher-return asset classes.
  • Using corporate assets to buy more gilts for pension schemes, potentially with money that will be needed as a buffer against economic downturns in future, could undermine the sponsor and ultimately the economy.
  • Some employers have already exceeded their capacity to support their scheme and cannot afford to walk away by buying annuities either. They are effectively prisoners of their scheme, thus harming competitiveness.  The current approach is trying to make the best, the enemy of the good.
  • To cope with the future run-off of DB schemes, Government should consider introducing a ‘Winding down regime’ that allows employers to sever ties with the scheme without having to buy annuities.
  • The prevalence of small and medium sized sub-scale schemes is hampering good outcomes, making benefits more expensive to deliver. A new regime is needed that can facilitate scheme mergers.  This will enable economies of scale to deliver more benefits, more reliably.
  • Although not ideal, I also believe the pragmatic approach is to allow schemes the chance to move indexation and revaluation from rpi to cpi. A statutory over-ride would recognise the unaffordability of some schemes for their sponsors and is the minimum adjustment that could help some schemes to manage their costs more sustainably.
  • Scheme mergers are going to be essential in the coming years. This will not only cut costs, but will also allow better governance and access to a wider range of investment opportunities.
  • Currently, there seems too much emphasis on ‘de-risking’ by means of switching to fixed income. This is, in my view, potentially damaging.
  • In light of exceptionally low bond yields, artificially distorted by central banks, the traditional risk models may be misleading. It is not clear that Government bonds offer ‘risk-free returns’ and in some cases they may be offering ‘return-free risks’.
  • Some schemes have lost out significantly by chasing gilts, rather than relying on supposedly higher risk assets.
  • Asset allocation now emphasises minimising risk, rather than maximising returns. This could be reckless conservatism and trustees need to manage investment risk, not just minimise it.  Given the uncertainty surrounding investment risk measures and the need to outperform (not just match) liabilities, switching to lower return holdings could increase the risk of failure.
  • Many smaller schemes do not have access to the most modern methods of money management and also fail to get the benefit of top advisers. Many do not have professional trustees or investment expertise on their board.  They would benefit from broader diversification and access to better investment approaches.
  • As we look forward over the next period, with most schemes closed, investment performance could be a key determinant of DB sustainability. Current sub-scale schemes are not likely to have the resources or expertise to make the most of the investment opportunities open to larger schemes.
  • The Regulator (and/or the PPF) may need new powers to negotiate terms on which schemes can ‘walk away’ from their liabilities, without full annuitisation. A new self-sufficiency regime would also require the Regulator to have increased powers to demand information from schemes, with penalties payable for non-compliance.
  • The Regulator should also have powers to facilitate scheme mergers on a more cost-effective basis, allowing trustees to judge what is in the best interests of members and, if they have made every reasonable effort to contact members, to allow them to ultimately consolidate or change the scheme without every single member’s consent.
  • Forcing sponsors to support unaffordable liabilities or go bust is a damaging binary choice. Using BHS as an example, it should be possible to devise a system whereby employers can pay a defined amount into their pension scheme, or commit to a programme of ongoing payments for, say, 5 years, that will end their responsibility.  This could be on the basis of technical provisions, plus a reasonable margin to allow for uncertainty.
  • The Regulator or PPF could introduce a range of consolidator funds to help manage long-term liabilities. These could invest assets in housing and infrastructure, as well as start-up businesses to provide an improved source of funding for the UK economy.
  • Small employers and charities urgently need relief from the draconian legal burdens that were originally designed in a different environment. For example, forcing plumbers to lose their homes and their entire life savings, just because they tried to provide pensions for a few of their staff, is disproportionately harsh.  Perhaps allowing them an RAA route can be considered.
  • Currently, there is little differentiation between requirements placed on open and closed schemes. An open scheme has very different characteristics, with much longer time horizons and greater ability to increase member contributions to cover rising costs over time.  It is closed schemes which need closest attention and consolidation.
  • I believe the Regulator should relax its attitude to DB to DC transfers. Many members, especially with small deferred entitlements, could benefit from transferring out, and the transfer value should, in my view, reflect any underfunding in the scheme. The assumption that it is almost never right for members to transfer is outdated, given the DC pension freedom changes.

1 comment

1 JENNIFER JONES { 05.16.17 at 8:47 am }

Great response Ros. I particularly agree with your last paragraph as I deal with clients requesting DB transfer on a regular basis. Some of them just want their cash for numerous reasons like buying commercial property for their business by transferring to a Sipp. average transfer advice costs from a DB is £5000. Personally I’m too scared to advise in this area because of the FCA’s attitude to advisers, so I refer them elsewhere.

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